There is a strong link between entrepreneurship and growth – young firms were responsible for almost all net job creation in the US economy over the last 30 years. This column presents new research into the responsiveness of firms of different ages to investment opportunities. Firms aged 0–23 months create about twice the total number of new jobs in response to local income shocks than firms that are more than six years old.

Economists have long been concerned with understanding how firms respond to changing investment opportunities. Indeed, this question is central to ongoing policy discussions about economic growth and job creation, since the way firms create jobs is by increasing investment and employment in response to new economic opportunities. The startup process and economic growth are deeply interconnected – over the last 30 years, young firms were responsible for almost all net job creation in the economy (Haltiwanger et al. 2009, 2013, Stangler and Litan 2009). In a recent working paper (Adelino et al. 2014), we look at the mechanisms behind the entrepreneurship–growth nexus by examining how young and old firms take advantage of new investment opportunities.

To assess the causal linkages between economic shocks, new businesses, and job creation, we focus on the response of firms in the non-tradable sector to local income shocks. Retail establishments and restaurants are not necessarily the engines of high-tech innovation in an economy, but we can very clearly pinpoint the source of their demand shocks. In particular, the non-tradable sector is almost entirely affected by local, as opposed to global, factors. To measure shocks to local income that might affect demand for the non-tradable sector in an area, we interact the industrial composition of a region with various measures of the nationwide change in manufacturing employment (as in Bartik 1991). The idea is that if an area has a lot of high-tech manufacturing, for example, it will experience a larger shock in response to a national surge in high-tech manufacturing than will regions heavily based on textiles.

There are good reasons to believe that older firms – especially in the non-tradable sector –might be more responsive to economic shocks than young firms. After all, many activities in this sector are inventory and capital intensive, and older firms might have an important advantage in being able to access capital or otherwise marshal the necessary resources. However, it is also easy to point to reasons why young firms might be more responsive to shocks than older firms. We think of startups as being more nimble, more flexible, and better able to make organisational changes to adjust to changing circumstances. In some sense, the question itself is a redux of Schumpeter’s work on the subject of innovation.

Empirical strategy

We use publicly-available US Census Quarterly Workforce Indicators data to compute total employment by firm age. This dataset allows us to measure total job creation among firms in different age buckets: startups, firms 2-3 years old, 4-5 years old, and over five years of age. We measure job creation geographically with commuting zones, which are geographic units larger than Metropolitan Statistical Areas that potentially span state lines, delineated according to the natural flow of labour around an urban centre.

The two figures below illustrate our empirical strategy. Figure 1 shows the change in local income between 2001 and 2007. Commuting zones in the lowest quintile of the distribution of income growth (below 1.5% growth over the six years) are shaded dark red, and the highest quintile (income growth above 12.8% in the same period) is shown in light yellow. Areas in grey are not included in our dataset because they are not covered by the Quarterly Workforce Indicators. Clearly, there is wide cross-sectional variation between different regions in the country, and we exploit this variation in our tests.

Because local income growth may be driven by a number of unobserved local factors that could also drive employment in the non-tradable sector, we use changes in local manufacturing employment that are caused by nationwide shocks to the manufacturing sector as an instrument for local income shocks. Figure 2 shows the shocks to local manufacturing employment. The bottom quintile in the distribution of local manufacturing employment growth is shown in dark red (representing a drop of more than 4.7% in local manufacturing employment), and the top quintile (a drop in manufacturing employment of less than 1.5%) is again shown in light yellow. The two figures make it clear that there is a strong relationship between manufacturing employment and local income growth, which validates our basic empirical approach.

Figure 1. Local income growth (2001–2007)

Figure 2. Growth in local manufacturing employment (2001–2007)

Startups are key to job creation

We then look at how firms of different ages react to the local income shocks described above. We find that startups in the non-tradable sector were much more responsive to shocks to local income than older firms.

Firms aged 0–23 months create about twice the total number of new jobs in response to local income shocks than firms that are more than 6 years old.

These results are robust to a number of empirical specifications, including different definitions of shocks to manufacturing employment and different time periods. The results are somewhat surprising, because about 85% of total jobs in the non-tradable sector are in older firms. Nevertheless, almost all the job growth in response to local income shocks occurs through the firm creation process itself.

The role of access to credit

While our evidence clearly favours the hypothesis that young firms are more responsive to new investment opportunities, it could still be the case that financing constraints create economically meaningful barriers preventing them from taking advantage of changing opportunities. To study how access to finance interacts with firms’ ability to pursue investment opportunities, we use the share of local banks in a region as a measure of local access to finance. A ‘local’ bank is defined as one that has 75% or more deposits concentrated in one area (following Cortes 2013). The assumption is that small (local) banks are more likely to be able to lend to small firms, and especially so to more opaque firms.

We find that the responsiveness to local income growth more than doubles in areas with a strong presence of ‘local’ banks.

Interestingly, the responsiveness of the old firms decreases in areas with high shares of local banks.

This suggests that in areas with easier access to credit for young businesses, the heightened responsiveness of young firms perhaps even crowds out the response of mature firms.

Policy implications

Our findings have a number of policy implications, and open the door to many fruitful questions. First, our work suggests that policies aimed at alleviating constraints to startup activity are likely to be more effective as a tool for job creation than broader policies targeted at the small business sector (where most firms are, in fact, old). Second, the results suggest that factors such as bureaucratic inflexibility, unobserved characteristics tied to the entrepreneur, and the strength of incentives play an important role even in less technologically sophisticated sectors. This is an important and ongoing research question in the economics of productivity, organisations, and management (see, for example, Bloom et al. 2013). Clearly, understanding the inherent organisational advantages that young firms have over older firms is essential for understanding the microfoundations of their increased sensitivity to changing economic conditions.